May 21, 2014

AFL for ATR based SL

Some time ago, I posted an AFL for a simple trailing stoploss.

Today I will write about ATR based stoplosses and how it differs from other stoplosses.

ATR stands for Average True Range and is a measure of volatility of a stock.

The ATR is the greatest of the following:
-current high minus current low.
-the absolute value of the current high minus the previous close.
-the absolute value of the current low minus the previous close.

The average true range is a moving average (generally 14-days) of the true ranges.

In other words, we are looking at average daily trading range of a stock. So if a stock is trading at Rs.100 and the ATR (14days) is 3, it means the stock has been trading in a Rs.3 range in past 2 weeks.

So as it is normal for the stock to move within a range of Rs.3, a stoploss of twice the ATR i.e. Rs.6 is provided. This ensures stock has room for movement while minimizing chances of a whipsaw.

For purpose of SL, the recommended strategy is to set the SL at twice the 14 day ATR.

For a long position: SL=H-2*ATR(14);
For a short position: SL=L+2*ATR(14);

Note that as the trading range of a stock changes over a period of time, the SL will also change and will automatically adjust itself to the changing volatility.

So in periods of high volatility, your SL is deeper (or bigger) as compared to periods of low volatility.

ATRs are therefore superior to using a fixed percentage because they change based on the trading range of the stock being traded. As the trading range expands or contracts, the distance between the stop and the closing price automatically adjusts and moves to an appropriate level, balancing the trader's desire to protect profits with the necessity of allowing the stock to move within its normal range

The AFL is...

And when plotted on chart...

Now it does not look impressive or fancy at all...  but what you need to understand is as the stock goes up, the blue line also follows. Now in any trailing SL method, it is important that the SL for a long position should be shifted only up and never down. By this logic, the horizontal blue (manually plotted) is the one where exit of a long trade happens.

Conversely, if you are short and the Short SL is simply increasing it means you are on the wrong side of the trade. For a short trade, the trailing SL should always come down and not go up.

Hope this helps.

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